On February 25, The New York Stock Exchange was closed not with the ring of a bell, but with a conspicuous "quack." Television viewers were treated to the unusual spectacle in celebration of the 10th birthday of the notorious Aflac (AFL) Duck. In a less celebrated moment, Aflac’s Issuer Default Rating was downgraded from an “A+” to an “A” by Fitch Ratings, citing increased leverage and an overweighted investment concentration in the financial sector as cause for concern. In the United States, Aflac is the number one provider of guaranteed-renewable insurance. In Japan, Aflac is the number one insurance company in terms of individual insurance policies in force with an extensive selection of supplemental cancer insurance.
In the insurance business, policyholders provide a constant stream of cash, which is invested in liquid marketable securities until insurance claims are made. Aflac draws cash for investments from more than 50 million people worldwide, creating a substantial pillow of cash. Insurance businesses spend millions to distinguish themselves through ad campaigns such as the Aflac Duck. Geico (BRK.A) (BRK.B) wields a massive $800 million advertising budget. As is true for the enitre insurance industry, Aflac must market aggressively in an effort to decommoditize a business in which the product is ultimately indistinguishable. Insurance policies are standardized and can be easily duplicated, it is easy to become a licensed insurer, and insurance rates are easily compared. All of these factors diminish firm pricing power on the supply side.
Lessons from the past: Warren Buffet
History illuminates the importance of financial strength to the long term health of any insurance firm. In March of 1967, Berskshire Hathaway (BRK.A) (BRK.B) purchased the National Indemnity Company and the National Fire and Marine Insurance Company. In “The Warren Buffet Way,” Robert G Hagstrom jr. describes the dilemma which insurance companies encountered in the 1970s.
“Although the consumer price index was rising 3% annually, medical and auto repair costs were rising three times faster. Furthermore, the damages awarded to plaintiff in court cases, damages that insurance companies had to pay, were increasing at an alarming rate. Buffet estimated that costs were rising approximately 1% per month.”
Margins began to squeeze while price competition spurred rival insurance companies to lower policy rates below the level of profitability. Anticipating falling costs in the future, firms attempted to gain market share at the expense of profit. Rival insurance firms incurred financial losses in the billions. Buffet remained aloof, refusing to sell policies below profitable rates even as market share temporarily eluded him. His business did less sales in the short term, but maintained its financial strength. Eventually, firms dropped out of the market as losses mounted, and Berkshire’s market share grew as consumers gravitated toward the safety Buffet's price premium guaranteed. Did this strategy work in the long run? Morningstar Research released an article on February 27 entitled “Insurance, Utilities Lead the Way for Berkshire.” The current standing of Berkshire Hathaway's most prominent insurance holding, Geico, will be discussed in greater detail in a future article.
No Cause for Alarm
Ultimately, low-cost insurance providers must reckon with a macro environment of increased competition, and cycles of uncontrollable external costs. Financial strength and sound investing is the formula for longevity. Aflac is still financially safe, with a total debt to equity ratio of only 9%. Consistently high returns on equity, improving after-tax profit margins, opportunities for growth in supplemental insurance, and increased market penetration will continue to place Aflac in a position of strength. The Issuer Default Rating downgrade does not need to be cause for alarm, but it is certainly worthy of careful consideration. Consumers desire low prices, extensive supplemental coverage, and financial strength from an insurance firm. Because of its enormous size, Aflac is able to offer and sustain all of these benefits for the near future.
Disclosure: No positions